From: John Martello [john.martello@tower-research.com]
Sent: Friday, March 26, 2004 4:12 PM
To: rule-comments@sec.gov
Subject: Summary of Intended Testimony -- Regulation NMS, File No.
S7-10-04
To: rule-comments@sec.gov
Summary of Intended Testimony -- Regulation NMS, File No. S7-10-04
John Martello
Managing Director
Tower Research Capital LLC
I will testify that two of the key Regulation NMS proposals - the trade-through
rule extension and the subpenny quoting ban -are flawed and will not accomplish
the Commission's goals but in fact will have the adverse effects of making
markets slower, less efficient, and less liquid, to the detriment of investors.
In contrast, investors are best served if the trade-through rule is eliminated
in all markets, and subpenny quoting is not only permitted, but encouraged. My
specific points are outlined below.
A. The trade-through rule creates an unfair advantage for slower market
centers
1. Under the current trade-through rule as applied to the NYSE, the
specialist has a free look-ahead period equal to the delay in the market. For
example, if it takes 5 seconds to cancel an order on the NYSE, and the quote can
be 5 seconds slow, if the market moves up after a marketable limit buy order is
sent by a market participant at what was the market ask, then that order usually
will not get filled. Conversely, if the market moves down after the same
marketable limit buy order has been transmitted by a market participant, if the
market participant attempts to cancel its buy, the specialist (who by virtue of
his market incumbency has the fastest information feed) will usually fill the
order before the cancel takes effect.
2. This look-ahead period can be most accurately represented by
examining the optionality of a non-instantaneous market order as described in
the Commission's Proposing Release 34-49325, and this optionality problem is the
strongest argument as to why the Commission should not allow slow exchanges the
same trade through rights as fast exchanges. As the Commission observed, a long
delay in a market center implies that the person trying to cross the market is
short an option for the time the order is outstanding. In effect, a customer
placing a buy order on a slow exchange is in effect granting a free put option
to the slow exchange. The optionality reflects a hidden charge for the person
trying to execute at that order, and therefore in all cases that value of the
put should be added to the slow market's price to make that price accurate, not
just in market crossing scenarios (a cost of trading on slow markets which I
believe most individual investors are completely unaware of). Therefore, if you
were trying to figure out how optimally to place a buy order and an ECN had a
price of $50.00 and a slow market maker had a price of $49.99, if the
optionality cost is over $.01 then it is actually better to place the order on
the automated market center at the worse price. Insisting on filling at the best
available price without accounting for market delays therefore results in
inherently worse fills for customer orders.
3. However, the Commission's attempt to estimate the cost of the option
was incorrect. Allowing a fixed variance based on NBBO price as a way of
accounting for optionality is inaccurate, and puts the government in the
business of setting options prices in the market, which it should not be doing.
The option has to be priced based on volatility, just like real-world options.
For example, securities derived from broad market indices, such as QQQ or SPY,
have inherently lower volatilities than the stocks that comprise those indices,
and NASDAQ stocks generally have higher volatility than NYSE stocks. These
differing volatilities result in vastly different costs of the option. Moreover,
in periods of high volatility these option costs are higher still. However,
under the proposed trade-through rule's minimum variation allowance, the
Commission is essentially proposing a fixed price for options of a given price
on these stocks. This illustrates a fundamental difficulty of having a trade-
through rule - it has a lot of unintended consequences, which if they are
fixable can only be fixed through even more detailed and complex regulation and
enforcement. It would be reasonable to assume with the current high level of
sophistication of the market that if these mandated option values are not
perfectly accurate then the unsophisticated customer will be exploited by market
participants capitalizing on an SEC-mandated arbitrage opportunity.
4. Non-automated execution facilities should be considered differently
than automated, as the Commission noted in its request for comments on response
times and degree of automation. Otherwise, an incentive will exist to create
the slowest-responding ECN which give sophisticated traders using that ECN the
greatest "look-ahead" period possible, and therefore the greatest value for
their free option. Therefore, the Commission should be careful in how it
determines what is an automated vs. non-automated execution facility. Response
times should be included in the definition, and an average market order
execution time of less than .75 seconds on average should be required for both
cancel confirms and market order fills (the NYSE by our data takes 2.6 seconds
for their auto-execution facility to execute). A .75 second market order
execution time is very achievable with current technology as evidenced by the
fact that it is a significantly slower fill time than what is average for all of
the major ECNs. Further, the automated facility should be fully automated in
all aspects, i.e., customers should be able to electronically place limit
orders, the size of order should not determine whether the order is electronic
or not, and the electronic market should operate even (and especially) in times
of high volatility. None of these capabilities currently exist for the NYSE
Direct+ system. Response times are even more important in times of very fast
moving markets, and at these times many automated and non-automated facilities
both slow down, which suggests that the Commission should set and enforce
standards for robustness of response times in both normal and fast-moving
markets.
5. I will also address the alternative proposal of the SEC, which is to
allow professional traders to lock or cross markets when they have a special
flag set in their order. This proposal seems to be in every conceivable
scenario better for the non-professional investor than disallowing locked or
crossed markets, though it is probably ideal to allow even non-professional
investors to lock or cross markets due to the previously stated reasoning on
optionality. If a professional investor crosses a slow market maker's offer
with his bid, a non-professional investor seeking to sell the stock would be
guaranteed a better price for the sell by the crossed amount, under all
circumstances. A non-professional investor wishing to buy the stock would not
be affected when compared to disallowing market crossing, under all
circumstances. The only effect that mandating a maximum crossing amount will
have is to lock in more profits for the professional trading community in
general: by mandating a maximum price that a professional is allowed to place a
bid, it in effect results in a lower bid relative to where the professional
community believes the price to be and therefore a greater profit if an
unsuspecting non-professional investor blindly places a sell order. Therefore, I
believe there is a very strong argument that no limits on the degree of crossing
should be in place, as it is only worse for the non-sophisticated investor.
B. Subpenny quoting has measurably improved market efficiency
1. Much of the Commission's justification for the subpenny quoting ban is
derived from out-of-date pricing and volume data, and should be reconsidered by
the Commission using current market data. Problems attributed to subpenny
quoting, such as lack of depth and "subpennying" of orders, have greatly
diminished since the early period of subpenny pricing and are far less
significant in the current subpenny market, as our studies of price and volume
data show. The fast evolution of these markets also implies that even tighter
spreads are achievable as the market steadily improves its efficiency. Limiting
the tightest allowable spread to $.01, which is the average spread for many
high-volume stocks today, legislates a maximum efficiency for the market instead
of allowing further improvement.
2. Complaints by large block traders that subpenny quoting makes block
trading more difficult should not outweigh the significant overall cost savings
created by subpennies. Large block traders have sophisticated, low-cost auto-
execution technology available to them that allows trading of large blocks with
minimal price impact (guaranteed VWAP, best-efforts VWAP, smart order routing,
etc.).
4. Subpenny trading creates demonstrably tighter spreads and lowers costs
for investors. Investors who pay the spread (by placing marketable limit orders
or market orders) have a cheaper fill rate under a subpenny regime. This is
especially relevant for low priced stocks (under $10), and very liquid stocks
where spreads are pegged at a penny. I will discuss analyses I have performed
of several widely-held securities which demonstrate that the aggregate price
savings to investors of subpennies is in fact economically significant - in the
hundreds of thousands of dollars per day for certain highly liquid stocks.